Agricultural commodities are a basic element of our economy and their exchange through transactional markets has been well established. In short, the process is extremely simple at a high level. Producers grow the various agricultural products and sell them to consumers at the best price they are able to obtain. Thus, the success of the producer depends on the price offered by the consumer and the quantities produced and ultimately sold. In practice, however, there is an extremely complex set of transactions that can actually occur in order to achieve this rather simple result.
Generally, the producers will sell and deliver their products to local intermediaries, such as elevator operators. The elevator operators then sell and deliver those products to end users/consumers (or to yet another middleman) who may be located anywhere. The elevator operator must generate a profit by selling the products at a higher price than paid to the producer, while taking into account the costs for storage and transportation. The producer realizes a profit when the products are sold to the intermediary at a price that is higher than the cost of production and transportation. One of the major considerations in these commodities transactions is that the margins are very low.
The prices for the commodities are not static and in fact can fluctuate dramatically based on any number of factors and issues. Centralized commodities exchanges have been established that allow for regulated transactions under these fluctuating conditions to occur. Through this system, the price of commodities is determinable, both at the present time and at least speculatively into the future. For example, the Chicago Board of Trade (CBOT) is such a commodities exchange and the prices indicated by that board become the de facto price of a given commodity world-wide. More accurately, the price indicated by CBOT serves as a base by which prices in given localities are determined. As an example, assume that a bushel of yellow corn is trading on CBOT for $2.00. That means, that a bushel of yellow corn delivered to Chicago, Ill. (during the specified time period that the price is good for) is worth $2.00.
Thus, if a producer can deliver his product to the Chicago area, that producer should receive the price for the commodity indicated by CBOT. In practice, this usually is not feasible. A farmer in Kansas who raises corn is usually not in a position to economically transport that corn to Chicago in quantities to make it worthwhile. Thus, the farmer delivers his corn to a local elevator operator and sells it there. The elevator operator is usually going to pay the farmer an amount that is based on the CBOT price. The price paid will depend on geographical location, transportation availability and cost, storage costs, etc.
To determine the amount paid to the local farmer, the elevator operator adds a basis price to the CBOT trading price. The basis includes the elevator's costs, such as transportation to market and costs associated with running the facilities, as well as the margin. For example, assuming transportation charges of $0.40/bushel and a margin of $0.04, the local farmer will be paid $1.56/bushel for yellow corn, when the CBOT trading price is $2.00/bushel ($2.00-$0.40-$0.04=$1.56). In this example, the elevator operator will realize a profit of $0.04/bushel when the corn is resold at the anticipated price.
This is obviously a very narrow margin for the elevator operator and this translates into a high degree of risk. Risk is incurred because delivery of the material is usually scheduled for some time after the agreement is completed. If at the time of delivery, the CBOT price has dropped the elevator operator is still obligated to pay the producer the amount agreed on. However, it will be difficult if not impossible for the elevator operator to resell the product at a price high enough to obtain his desired margin. In the above example, the margin was only $0.04. A minor shift in the commodities market can financially devastate the elevator operator.
To manage that risk, the elevator operator takes advantage of another element of the commodities exchange. For every contract that is generated with a producer, the elevator operator will place a hedge order. In the case of a cash purchase with a producer, a sell order would go into the commodities futures market. Continuing with the above example, assume that a producer wishes to sell to the elevator operator 500 bushels of yellow corn for delivery 3 month from today. Yellow corn is at $2.00/bushel at CBOT and the elevator operator agrees to pay the producer $1.56/bushel for delivery in three months. To cover his risk the elevator operator also works through a broker to sell 500 bushels of yellow corn in the futures market. The futures contract is for 500 bushels of yellow corn, deliverable in three months at a price of $2.00/bushel. If in three months when the elevator operator takes delivery from the producer, the trading price of yellow corn is down, the futures contract will prevent the elevator operator from realizing a loss. One way of looking at this is to assume that the elevator operator were to try and sell that corn on the market. Any potential buyer would look at the CBOT trading price, which is now below the $2.00 level and only be willing to pay a reduced amount. However, the elevator operator has the futures contract for a sale at the price of $2.00/bushel. Thus, the margin of $0.04 is maintained. Conversely, if the trading price goes up, purchasers will be willing to give the elevator operator an amount exceeding $2.00 a bushel, but the elevator operator still must fulfill his future contract to sell at $2.00.
Thus, the futures markets serves as a hedging tool to minimize risk for the various intermediaries, such as the elevator operators. As a practical matter, these various futures contracts are usually unwound in various ways without requiring actual delivery of the commodity. Therefore, it provides a truly advantageous function to the intermediary.
All of this simply lays a groundwork for commodities exchanges on the local level. The elevator operator negotiates with a local producer on price. When a tentative agreement is reached, the elevator operator tries to sell a futures contract to minimize risk. If an acceptable futures contract is obtained, the elevator operator then formally agrees to accept the contract with the producer. In effect, two contracts are negotiated and ratified for the sale of a commodity from a producer to an elevator operator.
As discussed above, the producer will have various subjective and objective incentives to deal with certain elevator operators. One obvious consideration is the proximity of the elevator to the producer. Past dealings with a given elevator operator would be another consideration. Whatever the reasons may be, a given producer will have several elevator operators that they might choose to deal with. At a given time, the producer will decide to sell a quantity of a product. The producer must call these various operators to determine what they will be paying. When an elevator operator receives such a call, he must then call a broker on the CBOT to determine what the current trading price of the commodity is. Then the elevator operator subtracts his basis to determine a flat price. Assuming that elevator is capable of handling it, the elevator operator makes an offer to buy a specified quantity of the commodity and a contract is ratified. The operator then secures a futures contract for the appropriate amount with another phone call to a broker. Of course, after hearing the flat price offered, the producer may refuse to proceed or attempt to renegotiate. In the later case, more calls to the broker may be necessary to determine if the required futures contracts can be obtained.
This process is slow and tedious when it works, but at times it is completely incapable of functioning. The elevator operators may be unavailable when the producers call or unable to immediately track down the required information. The commodities exchanges are only available during certain hours, thus further limiting the process. Even when the exchanges are open, securing quotes and placing orders by telephone is often a delayed process. In short, this can be drawn out process and fails to realize a high degree of efficiency.
Therefore, there exists a need to provide an automated service that allows for interaction between producers and intermediaries that can obtain and display real-time relevant data and allow for the required hedging activities to occur at any time, while facilitating the completion of commodities transactions.